Volkswagen and method of their deception. The technology VW

VolkswagenScandal-An issue of Ethics, Emission and RetributionAbriefAneconomic perspective of the ‘Dieselgate’ scandal involves much more thannitrogen oxide, competitive pressure and corporate memos. It involvesquestioning the very ethics and principals of the leaders running the company andunder whose watch such a scandal took place. It marks a huge dent in thecorporate governance of the companies worldwide and acts as an eye opener forthe people highlighting the importance of an external body to oversee theimplementation of governance and ethics in an organisation.Around a decade or so ago,Volkswagen wanted growth pretty badly. It was fighting Toyota and GeneralMotors for the number one position in the car market globally. The obviousplace for it to grow was the huge US market, where it had a very minimal marketshare.

Due to the tax incentives in Europe, VW had special expertise in makingsmall diesel engines. Also, these engines produced lesser carbon dioxide thanpetrol engines and thus selling them was easier owing to the greenhouse gasrules. Given its commercial footprint, technical strengths and the regulatoryclimate, the economically optimal strategy for VW was to go with small dieselsin the US. There was one small problem. USrules about nitrogen oxide emissions — where diesel is a worse offender thanpetrol — are tougher than European ones. The technology that enables cars tomeet them is expensive, making it practically impossible to produce amid-priced car that passes muster.

While it wasno hidden fact that manufacturers attempted to ‘work around’ these tests, whatwas astonishing about VW’s case was the scale and method of their deception.The technology VW used for cleansing Nitrous Oxide emissions involved atrade-off against fuel economy and performance, which VW’s engineers andprogrammers decided to manage by introducing two distinct driving ‘modes’ intothe car’s software- a ‘best behaviour’ mode that complied with US Nitrous Oxideemissions requirements, and another for all other circumstances. The car systemswere smart enough to detect whether they were undergoing the highly predictableand fancy requirements of the US Environmental Protection Agency (EPA)’s tests,and put themselves on best behaviour accordingly. However, the deviation wassignificant. The cars emitted up to 40 times more Nitrous Oxide during normalcircumstances than under test conditions. About500,000 vehicles were affected in the US, spanning the model years 2009-16.

Thetactic was used in other markets as well, raising the total number of affectedvehicles to approximately 11 million worldwide.It appearsthat cost saving was a key motivator. VW’s competitors in selling diesel carsinto the US market- BMW and Mercedes developed a more expensive technology forcleansing diesel fumes of particulates and Nitrous Oxide specifically, known asurea filtering. By choosing not tolicense this technology from Mercedes, analysts estimate VW could havesaved up to $4.8bn worldwide.The losses suffered by VWDetails oftheir expected quantum emerged in late April from VW’s 2015 Annual Report andthe announcement of an agreement in principle regarding a settlement withUS authorities and class-action lawyers, under which VW reportedly agrees to repair or buy back the cars sold inthe US with the illegal software, and to pay additional compensation.

Inaddition, the US Department of Justice has opened a criminal investigation, andcivil, criminal and/or administrative actions have been commenced in many othercountries.VW’s 2015Annual Report announced provisions totalling €16.4 billion ($18.4 billion)for the clean-up and legal costs, including €7.0 billion ($8.0 billion) dollarsfor “legal risks” and a further €1 billion ($1.2 billion) for contingent liabilities.VW also began a product recall in the EU of cars sold with affectedengines.

VW’s stockprice fell rapidly by 40% after this scandal came to light, although itsubsequently regained ground, now wavering at just under 20% down. Thissuggests the market’s estimate of VW’s likely losses is similar to the firm’sprovisions, at around $18 billion.  As a result, it doesn’t seem that VW’scase bucks the trend of purely environmental harms (as opposed to uncompensatedharms to customers) not triggering reputational losses.The Management inactionAnycompany cheating its customers depends highly on expectations about theprobability of getting caught, and attitudes to risk. Consider first the(highly implausible) idea that the decision to cheat was in fact deliberatelytaken by management, assuming that the benefit was $5bn and the costs were$18bn. This would have a positive expected return for VW provided that theprobability of getting caught was less than approximately 25%. Now consider the(much more plausible) position of a CEO who has a whiff that something may beamiss amongst junior engineers. He can either pursue an internal investigation,which will alienate engineers and may reveal wrongdoing.

Or he can do nothingand press on regardless. The problem is that an internal investigation wouldsurely increase the likelihood that the firm will get caught for any priormisconduct. If the CEO judges the initial probability of getting caught to below, it is easy to see that it may maximise expected profits to turn a blind eye,rather than draw attention to a potential problem. The executives, being riskaverse, failed to launch an internal investigation into extensive emissionscheating. In firmswith dispersed share ownership, high-powered incentives in the form of heavilyperformance-related pay are conventionally deployed as a way of encouragingmanagers to be less risk averse with respect to business decision-making.

The’performance’ criterion is normally defined by reference to the stock price,and it is ‘high powered’ because it responds aggressively to changes in thecriterion. This is known to give rise to problems when it comes to compliancewith corporate obligations imposed for purposes other than to maximiseshareholder value: examples being Enron, or the banks prior to the financialcrisis of 2008.What theVW case exposes is that high powered incentives can be linked to complianceproblems, even in firms that do not ostensibly have a culture of pursuing’shareholder value’.

Like all large German firms, VW had a two-tier board structure.VW’s CEO, Martin Winterkorn, had a pay package that was heavily tilted towardsvariable pay. In 2014, he took home €16m ($18.3m), of which only €2m($2.3m), or 12.5%, was fixed compensation. The heavy tilting towardsperformance related pay was common across members of VW’s Vorstand, orManagement Board. While executives’ variable pay was not tied directly to theshare price, it was linked closely to a number of metrics including operatingprofits, sales growth, customer satisfaction and employee productivity andsatisfaction.

This is consistent with the publicly-announced goal for VW formany years, namely growth: the goal was to make VW the largest car maker bysales in the world, which it ironically achieved in the first half of 2015,only to lose again in the wake of the scandal.Financialincentives were not the only high-powered incentives acting upon senior VWexecutives. There will also have been intensive monitoring by the Aufsichtsrat,or Supervisory Board. Unlike Anglo-American corporations’ boards, Germansupervisory boards are staffed with representatives of major shareholders andlabour. Thus VW’s Aufsichtsrat of 21 had 5 members appointed by the Porschefamily, the controlling shareholder, 2 appointed by the Qatar Sovereign wealthfund (which holds a 17% stake), 2 appointed by the state of Lower Saxony(holding a 20% stake), 10 appointed by employees, trade unions, and middlemanagement. The other two comprised the Supervisory Board’s venerable formerChairman, and a single independent.

Growth was an ambition that pleased bothstakeholder groups dominating the Aufsichtsrat, the controlling shareholdersand the employeesAstonishingly,the bias toward performance pay was shared by VW’s Aufsichtsrat. The Chair ofthe Aufsichtsrat, until April 2015 Ferdinand Piëch, took home €1.5m in2014, of which only €200,000 (13%) was fixed; this ratio was similar across theentire Aufsichtsrat. The Aufsichtsrat’s variable pay is expressly linked by §17of VW’s Satzung, or Articles of Association, to shareholder dividends.

AlthoughEuropean executives are usually thought to earn less than their counterparts inthe US, it is notable that Winterkorn’s package was very similar to the totalamount earned by Mark Fields, the CEO of Ford ($18.6m) and more thanthat of Mary Barra, the CEO of GM ($16.2m), in the same year.Financial incentives and close monitoring of performance is likely additive interms of their impact on executive behaviour.

Thus the intensity of thecombined incentives might have been even stronger than those faced by a USexecutive. In short, high-powered incentives can give rise to perverseincentives in firms without dispersed share ownership, and where performancetargets are not defined solely by reference to the share price.What alsoemerges starkly from the VW affair is the importance of distinguishing betweenagency costs and externalities in discussions of corporate governance.Conflicts of interest between managers and shareholders are an agency cost. Butso too are conflicts of interest between employees and shareholders.

Harmcaused to the environment, or any other interest external to the corporation,however, is an externality. Simply because a company’s structure is designed—ascodetermination does in Germany—to minimise agency costs between shareholdersand employees—does not necessarily imply that it will be less problematic interms of externalities. Corporate conduct that harms the environment but leadsto corporate growth benefits both investors and employees.Lessons for corporate governancefrom VW scandalThere areclearly lessons to be learned about the appropriate use of high poweredincentives.

However, the most striking implication would seem to be the needfor effective personal liability for individuals who either deliberatelyengages in misconduct, or who fail to ensure the implementation of sufficientrisk management. The former, which would be criminal liability, is already inplace in most jurisdictions, but suffers from serious problems of proof. Thelatter, however, which would take the form of negligence based liability, couldusefully be strengthened.Anotherpossibility might be to contemplate public enforcement of directors’ dutiesunder these circumstances.

This model is adopted in Australia, where ASIC haspower to enforce directors’ private law duties.Allthis presupposes some guidance as to what sort of actions such oversight shouldinvolve. Here we move into the realm of ‘risk management’. The VW case has somevery interesting pointers about this too. The striking thing about the VW caseis how the actions of a small number of technical personnel can lead to harmsaffecting 11 million vehicles.